Debunking Bernanke's Myth

In his interview with "60 Minutes", Federal Reserve (Fed) Chairman Ben Bernanke
suggested it is a myth that quantitative easing implies printing money. With
all due respect, Mr. Bernanke, if it looks like a duck and quacks like a duck,
it is a duck!

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Insights provide the Merk Perspective on currencies, global imbalances,
the trade deficit, the socio-economic impact of the U.S. administration's
policies and more.

Bernanke argues his policies do not amount to printing money, as neither currency
in circulation, nor money supply has increased. This analogy is a bit like
giving a loaded gun to a kid, then telling your friends that it's not a deadly
weapon because the shots that have been fired haven't killed anyone. Granted,
we are exaggerating here because, after all, it's only money we are talking
about. Yet, printing money may destroy one's purchasing power and thus one's
life's savings.

Indeed, the Fed doesn't only print money, but prints "super money". The money
the Fed prints is more powerful than currency in circulation. It's money made
available to the banking system. When the Fed buys government bonds, or any
other security, from a bank, the Fed credit's the bank's account at the Federal
Reserve, with the amount due. That "money", however, is merely an entry on
the computer system at the Fed - it's literally created out of thin air. It's
not physically, but electronically printed. A bank with cash in its hands can
create new loans; those loans may be deposited elsewhere by the person taking
the loan; money created by the Fed out of thin air can have a multiplier effect
of 1:100 by the time it makes its way through the economy. The loaded guns
handed to the kids are not a water pistols, but automatic weapons.

The kids, of course, are the banks. So far, the latest scolding (the 2008
financial crisis) remains fresh in their minds, and they are thus reluctant
to pull the guns' safety. But make no mistake about it: the banks are being
handed potent weapons. Indeed, the Fed would love to see the banks pull the
trigger and hand out more loans. It turns out the banks are not finding enough
creditworthy borrowers.

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Financial Security in a Volatile World of Debt and Consumption is available
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Truth be told, the money does make it somewhere, but the Fed cannot control
where the money flows (have you ever tried to control a little kid? Please
do not try this at home). Instead of flowing to where the Fed would like to
see all that freshly printed money go, it ends up in assets with the greatest
monetary sensitivity: precious metals, commodities, as well as outside of the
U.S. dollar. Courtesy of the Fed's "mythical printing", gasoline is as high
as $3.50 a gallon at some gas stations in California.

The money doesn't "stick" where the Fed would like it to because the Fed is
fighting market forces. Consumers would love to get their house in order -
quite literally: without massive fiscal (read: cash-for-clunkers) and monetary
(read: credit easing, monetary easing) intervention, over-extended consumers
would downsize further. However, "downsizing" implies foreclosures and bankruptcies:
promoting such a course of events could well be political suicide for policy
makers. Well, it appears Bernanke believes that if you simply throw enough
money at the problem - trillions of dollars worth - you might just get some
of that money to flow where you want it.

Bernanke brushed off his critics, arguing those critical of his policies are
not considering the risks should nothing be done, namely deflation. We are
not quite as concerned as Bernanke is about lower wages, as that may well be
an answer to reduce the oversupply of the unemployed. But it is not the argument
of deflation or inflation we are most concerned about. Let's remember: in the
run-up to the financial crisis, bad things happened. This is not the place
to argue whether it was the bad banks, bad consumers, bad regulators or bad
politicians causing the crisis (in the spirit of the season: let he who is
without sin cast the first stone!). No, the real problem is that the massive
and ongoing intervention by policy makers led us to believe that there is a
magic wand - the Fed's printing press included - that can fix our sorrows.
Because the government has come to the rescue with such great force, the financial
reform bill may not be worthy of its name; our system is no better than before
the crisis; on top of that, we may be setting ourselves up for a much worse
crisis further down the road. Beyond regulatory reform, there is also no incentive
to engage in fiscal reform as the Fed helps financing the government deficit.

On that note, the reason we are far more optimistic about the Eurozone than
most is because the sense of urgency hasn't gotten lost there. Real reform
is implemented as the European Central Bank (ECB) has reduced liquidity (that's
the opposite of money printing - just as mystical) by hundreds of billions
of euros this year. Yes, there are real problems in Europe, but there's a wonderful
dialogue between the markets and policy makers. Policy makers don't like the
medicine they are prescribed by those "speculators", but structural reform
is greatly expedited. In contrast, in the U.S., we are merrily printing money
because - well, in our assessment, U.S. policy makers simply believe they can
still get away with it.

It turns out the ECB's divergence from the Fed is not a recent, but a decade
old phenomenon. In an effort to impose structural reform, the ECB has kept
the Eurozone on a far tighter leash than the Fed has kept the U.S. economy.
As a result, European consumers are generally far less leveraged than U.S.
consumers (with notable exceptions in some regions). In the U.S., if monetary
policy were to be tightened, it may well throw the U.S. economy into a depression;
in contrast, those European consumers that stopped spending won't cut back
much further. Quite the contrary, German consumers in particular are starting
to embrace the holiday spirit after years of holding back. In more mundane
terms: the euro may well outperform the U.S. dollar because less money is being
printed in the Eurozone.

This leads us to the future: in our assessment, the Fed's worst nightmare
may well be that this mythical money makes its way through the economy. Bernanke
said he could raise interest rates in "15 minutes" should the economy need
to be tamed. That's a cute pun on a TV program called "60 Minutes", but ignores
a philosophical and a practical challenge: Bernanke has extensively argued
that tightening monetary policy too early after a recovery took place was a
key policy mistake of the 1930s; to us, it appears highly unlikely that the
Fed will apply any 15 minute policy to the U.S. economy.

Let's give the Fed the benefit of doubt for a moment - after all, we believe
the men and women at the Federal Reserve Open Market Committee (FOMC), the
group that decides on monetary policy, has the best of intentions. Here's the
challenge: by fighting market forces, we keep, or quite possibly expand, the
extensive leverage in the economy. As a direct result, the U.S. economy is
exceedingly sensitive to monetary policy. Think of it this way: if you have
no debt, you couldn't care less about interest rates. If you have loads of
credit cards bill, in addition to a large mortgage, the amount of sleep you
get every night may be highly correlated to interest rates. So if the Fed gets
its wish and we get strong economic growth, how on earth is the Fed going to
mop up all the liquidity they are saturating the economy with? The technicalities
aside (we have issues with those, too), we have grave concerns that as soon
as the Fed would indeed start tightening, it would have a far more amplified
effect than they anticipate, causing the economy to plunge rather sharply.

In a "best case" scenario, we may end up with a rather volatile Fed policy
in the years to come, bouncing back and forth between full-speed ahead and
applying the emergency brakes. As it turns out, very little, if anything, has
really worked according to the "best case scenario" in recent years. In this
context, please pardon our assessment that the risks of quantitative easing
far outweigh the potential "benefits."

What are those "benefits" anyway? At the risk of great simplification, it's
all about home prices. Millions of homeowners are under water. To remedy the
situation, homeowners can downsize (the healthiest from a macro point of view,
but politically not an option); pay down their debt (may happen individually,
but real wages haven't gone anywhere in a decade, thus making it an unlikely
option); or, alternatively, the Fed can employ its mythical printing press
in an effort to push up the price level. The "benefits" thus go to those with
too much debt; the pain goes to those who have been savers, including pensioners.
The policies are rewarding speculation; not just any, but the type of speculation
that chases the next great intervention by policy makers, not the next great
business opportunity. Asset classes have become increasingly correlated as
a result.

Excessively accommodating monetary policy fosters capital misallocation; those
in desperate need of yield may be buying ever longer-dated and riskier securities.
The greatest bubble in monetary history may have been in the making, a bond
bubble (see our analysis Bond,
Junk Bond - Casino Royale).

Talking about myths, there is a myth that Bernanke continues to promote: the
myth that the Fed can fight inflation. Even central bank super-hero Paul Volcker,
who is credited with "beating inflation" in the early 1980s, merely got the
annual inflation rate back down to earth. When central bankers pat themselves
on the back for "beating" inflation, we never come back down to the price level
before inflation started - monetary super-heroes are those who can stop the
bleeding.

To end this on a conciliatory note, we agree with Bernanke that one should
never underestimate the determination of the Fed. However, that's because,
in our assessment, inflation is not primarily a function of the "slack in the
economy", the "output gap" as economists like to call it, but a function of
inflation expectations: if consumers and businesses believe we will get inflation,
they will push for higher wages and prices. And because the Fed has the power
of the printing press, it's the Fed that can control inflation expectations
- if it only has the will. When Volcker "beat" inflation, many were skeptical
about his determination until proven wrong. Now it's Bernanke that has empathetically
called for inflation to rise. Again, some are skeptical; we believe those skeptics
will be proven wrong. Indeed, longer-term inflation expectations have been
ticking upward ever since Bernanke said in August that the Fed will "strongly
resist" inflation expectations falling too low.

In this context, investors may want to consider diversifying beyond the U.S.
dollar to mitigate the risks of the Fed's policies. We manage the Merk Absolute
Return Currency Fund, the Merk Asian Currency Fund, and the Merk Hard Currency
Fund; transparent no-load currency mutual funds that do not typically employ
leverage. To learn more about the Funds, please visit www.merkfunds.com.

Axel Merk, President & CIO of Merk Investments, LLC, is an expert on hard
money, macro trends and international investing. He is considered an authority
on currencies.

The Merk Absolute Return Currency Fund seeks to generate positive absolute
returns by investing in currencies. The Fund is a pure-play on currencies,
aiming to profit regardless of the direction of the U.S. dollar or traditional
asset classes.

The Merk Asian Currency Fund seeks to profit from a rise in Asian currencies
versus the U.S. dollar. The Fund typically invests in a basket of Asian currencies
that may include, but are not limited to, the currencies of China, Hong Kong,
Japan, India, Indonesia, Malaysia, the Philippines, Singapore, South Korea,
Taiwan and Thailand.

The Funds may be appropriate for you if you are pursuing a long-term goal
with a currency component to your portfolio; are willing to tolerate the risks
associated with investments in foreign currencies; or are looking for a way
to potentially mitigate downside risk in or profit from a secular bear market.
For more information on the Funds and to download a prospectus, please visit www.merkfunds.com.

Investors should consider the investment objectives, risks and charges
and expenses of the Merk Funds carefully before investing. This and other
information is in the prospectus, a copy of which may be obtained by visiting
the Funds' website at www.merkfunds.com or calling 866-MERK FUND. Please
read the prospectus carefully before you invest.

The Funds primarily invest in foreign currencies and as such, changes in
currency exchange rates will affect the value of what the Funds own and the
price of the Funds' shares. Investing in foreign instruments bears a greater
risk than investing in domestic instruments for reasons such as volatility
of currency exchange rates and, in some cases, limited geographic focus,
political and economic instability, and relatively illiquid markets. The
Funds are subject to interest rate risk which is the risk that debt securities
in the Funds' portfolio will decline in value because of increases in market
interest rates. The Funds may also invest in derivative securities which
can be volatile and involve various types and degrees of risk. As a non-diversified
fund, the Merk Hard Currency Fund will be subject to more investment risk
and potential for volatility than a diversified fund because its portfolio
may, at times, focus on a limited number of issuers. For a more complete
discussion of these and other Fund risks please refer to the Funds' prospectuses.

This report was prepared by Merk
Investments LLC, and reflects the current opinion of the authors. It
is based upon sources and data believed to be accurate and reliable. Merk
Investments LLC makes no representation regarding the advisability of investing
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are subject to change without notice. This information does not constitute
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The information contained herein is general in nature and is provided solely
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